Capital Losses

A capital loss is the financial ouch-moment that occurs when you sell an asset—like a stock, bond, or piece of real estate—for less than you paid for it. The official “purchase price” is known as your cost basis (or tax basis), which includes not just the price of the asset but also any associated commissions or fees. For instance, if you buy a stock for $1,000 and pay a $10 commission, your cost basis is $1,010. If you later sell it for $900, you have a “realized” capital loss of $110. It’s the direct opposite of a capital gain, which happens when you sell an asset for a profit. While no one enjoys seeing their investments decline in value, capital losses aren't just bad news. For a savvy investor, they can be a surprisingly useful tool, especially when tax season rolls around.

While a capital loss stings the ego and the wallet, it has a powerful silver lining: it can lower your tax bill. This strategic move is known as tax-loss harvesting. It involves intentionally selling investments at a loss to offset the taxes you owe on your capital gains. Think of it as turning your investment lemons into tax-reduction lemonade. By carefully managing your losses, you can significantly reduce your tax burden, freeing up capital to reinvest elsewhere. This isn't about celebrating failure; it's about making smart, pragmatic decisions with the hand you're dealt.

The tax systems in both the U.S. and many European countries allow investors to use capital losses to their advantage in two primary ways: offsetting gains and, to a limited extent, offsetting regular income.

Your losses are first used to cancel out your gains. The rules generally match short-term losses (on assets held for one year or less) with short-term gains, and long-term losses with long-term gains.

• Step 1: Short-term losses are deducted from short-term gains.
• Step 2: Long-term losses are deducted from long-term gains.
• Step 3: If you have any net losses left over in one category, you can use them to offset gains in the other.

For example, if you have a $5,000 short-term gain and a $2,000 short-term loss, you only owe tax on a net gain of $3,000. If you also had a $1,000 long-term loss, you could use that to further reduce your taxable gain to just $2,000.

What if your losses are bigger than your gains? The good news continues. After you've wiped out all your capital gains for the year, you can typically deduct a certain amount of your remaining capital losses against your ordinary income (like your salary). In the United States, this amount is capped at $3,000 per year. If your net loss is greater than this annual limit, you don’t lose the rest. The remaining amount can be carried forward indefinitely to future tax years. This is called a tax-loss carryforward, and it can be used to offset gains or income in the years to come.

A true value investor, following in the footsteps of Benjamin Graham, knows the difference between a temporary price drop and a permanent loss of capital. This distinction is crucial.

When a stock you own drops in price but you continue to hold it, you have an unrealized loss—it’s only a loss on paper. This is just Mr. Market, Graham's famous allegory for the stock market's mood swings, having a pessimistic day. An unrealized loss only becomes a realized loss—the kind that impacts your taxes and your real-world wealth—when you actually sell the asset. For a value investor, a falling stock price isn't automatically a reason to sell. The key question is: Has the underlying value of the business deteriorated, or is the market just panicking? If the business is still sound, a lower price can be a fantastic opportunity to buy more, not a signal to lock in a loss. The goal is to avoid a permanent loss of capital, which happens when you sell a great company at a terrible price or hold onto a deteriorating business all the way to zero.

Before you rush to sell a losing stock just to harvest the tax loss, you must know about the wash-sale rule. This rule prevents investors from claiming a tax loss on a sale if they buy the same or “substantially identical” securities within a 61-day window—that is, 30 days before the sale, the day of the sale, and 30 days after the sale. For example, if you sell 100 shares of Company XYZ at a loss on June 15th, you cannot claim that loss for tax purposes if you bought 100 shares of XYZ on May 20th or if you buy them back on July 10th. The tax authorities created this rule to stop people from gaming the system by selling for a quick tax break while essentially never leaving their investment position. If you violate the rule, the loss is disallowed for the current year and is instead added to the cost basis of the new shares you bought.